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Go Global With Closed-End Funds

Closed-end funds could provide open-ended gains.

Motley Fool Staff

Jul 28, 2008 at 12:00AM

Despite this year's turbulence in world markets, returns on international stocks over the past several years have been red-hot. As measured by Morgan Stanley's MSCI-EAFE index, which includes stocks in developed countries around the world, international stocks have returned an average of more than 12% annually over the past five years in U.S. dollar terms. If you expand your scope to include stocks in emerging-market countries such as China, India, Russia, and Brazil, you'll find other MSCI indices returning more than twice those of the MSCI-EAFE index.

Closed-end mutual funds are one way to own shares in foreign countries. Like exchange-traded funds, closed-end funds trade on stock exchanges, rather than being purchased directly from the mutual fund company. Unlike most exchange-traded funds, however, many closed-end funds have actively managed portfolios that fund managers can modify on an ongoing basis to react to changing market conditions.

Why closed-end funds?High-flying international market returns have prompted an explosion in the number of ways to invest globally. Many foreign companies list their stocks directly on U.S. stock exchanges, making them available to anyone with a standard brokerage account. A number of exchange-traded funds, such as iShares' series of index-tracking country funds, give investors broad exposure to a range of companies within a particular country. Mutual fund inflows into international funds have been extremely high in relation to money going into domestic stock funds.

Because of all of the ways in which you can participate in the booming international stock market, you may wonder how closed-end funds distinguish themselves.

In the global arena, closed-end funds have several advantages over other kinds of investments. Closed-end funds offer both investors and managers a chance to work with each other under favorable conditions, in comparison with traditional mutual funds. At the same time, the opportunity to buy shares at a discount can make closed-end investing more lucrative.

Access to efficient fund managementFor investors seeking active management of their investments, international closed-end funds sometimes represent the cheapest way to gain access to a particular fund manager. For example, Franklin Templeton fund manager Mark Mobius has won a number of awards for his work in managing investments in emerging markets around the world. If you want to invest in the traditional mutual funds he manages, however, you'll probably have to pay a sales load of as much as 5.75%. On the other hand, you can buy shares of closed-end funds he manages, such as Templeton Dragon Fund(NYSE:TDF) or Templeton Emerging Markets Fund(NYSE:EMF), for no more than the cost of your purchase commission.

Closed-end funds' structure makes them easier to manage than traditional mutual funds. Because investors in traditional mutual funds can buy or sell shares at any time, the managers of those funds must constantly deal with flows of money going in or out of their funds and adjust their investing portfolios accordingly. When too much money comes in at once, managers may find it difficult to locate enough suitable investment opportunities. Because many foreign stock markets have significantly less liquidity than investors are used to seeing in the United States, this problem is of particular concern to international fund managers. On the other hand, if money is flowing out of the fund, fund managers may have to liquidate assets, even if they believe that those assets would perform well for their investors.

Closed-end fund managers, by comparison, don't have to worry about money flowing in or out of their funds. Once the public offering of closed-end-fund shares is complete, transactions involving shares of closed-end funds occur solely in the secondary market, with absolutely no effect on the fund or its assets. Managers can focus on the money they have, knowing that it is all that they may ever have to invest for their shareholders.

Discounts on closed-end fundsThe other primary advantage that some closed-end funds have is that they may trade at a discount to the value of the assets they own. With funds focusing on international stocks, it's not uncommon to see discounts of 10% or more.

However, don't expect to see discounts on every international closed-end fund. Because investing in some international markets can be extremely difficult, closed-end funds sometimes offer the only access to a particular country or region. For example, although many large Japanese companies have listed shares on U.S. stock exchanges, it's harder for investors to buy shares of smaller companies in Japan. As a result, the Japan Smaller Capitalization Fund(NYSE:JOF) often trades at a premium to net asset value, especially when investing in Japan is in vogue. Similar situations are visible in the shares of the Thai Fund(NYSE:TTF), Thai Capital Fund(NYSE:TF), and Indonesia Fund(NYSE:IF).

Depending on what you're looking for in an international investment, closed-end funds are worth your consideration. In some cases, they offer the best way to focus your investment exactly how you want, while you get to retain the advantages of active asset management.

This article, written by Dan Caplinger, was originally published onJan. 29, 2007 and has been updated byKristin Graham.

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